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Co-op Bank Bailout Confirms Need for Caution

With interest rates available on the High
Street remaining painfully low, savers and investors have increasingly been
attracted to the relatively high rates of return and capital protection offered
by retail bonds and it is now estimated that around £3.4billion is invested in
these products in the UK.

Initially, the market was dominated by big
household names who wanted to raise extra capital.

An early launch on the ORB exchange was by Tesco
Personal Finance which attracted £125 million by promising to pay 5% for eight
years; National Grid pulled in £260million with an offer of inflation plus 1.25%
for ten years, and water company Severn Trent raised £75million, promising to
beat inflation by 1.3%.

Largely based upon the recognition of, and trust in,
the brand of the issuers these offers all sold out within days.

However, interest-starved savers and investors, and
particularly vulnerable pensioners who have sought to augment often meagre
state pensions with income on savings, have increasingly been attracted to an
investment in companies with which they may be less familiar.

"....desperate savers may be lending up to £4m a day to companies they know very little about"

In total a hundred and eighty companies are now
listed on the retail bond market, and the recent early closure of the 6% offer
from property developer Helical Bar suggests that desperate savers may be
lending up to £4million a day to companies they know very little about.

Caveat Emptor

In a recent article (Caveat Emptor – Mr Bond Urges
Caution When Purchasing ‘Retail Bonds’ – 7th June 2013) Retail Bond Expert
(RBE) called for investors to be given access to full and transparent
information that allows them to make informed investment decisions and
understand the risks to which they are potentially exposed.

RBE also called for standardisation in the way that
the various product types collectively known as retail bonds are presented,
including loyalty bonds which have sought to lure investors with a range of
incentives as diverse as chocolate and shopping vouchers.

The sentiment behind RBE’s call for caution was
entirely endorsed by this week’s £1.5billion bailout for Co-op Bank which laid
bare the danger for those who abandon High Street savings for bonds.

As part of a rescue bid to shore up the mutual,
7,000 members who invested £1,000 or more in the bank’s Permanent Interest
Bearing Shares (PIBS), which have many similar characteristics to retail bonds, face a
drastic cut in income and a likely loss of capital as the group plans to
convert them into shares.

In short, Co-op Bank plans to use the money invested
by bond-holders, often pensioners, in what was promoted as an ethically sound
and financially secure proposition, to shore up its finances; there are fears
that a similar fate could befall retail-bond investors, particularly if they
unwittingly back a firm that hits parlous financial straits.

Know The Facts Prior To Purchase

As before RBE urges potential investors and their
advisers to ensure that they are in possession of all the facts before lending
to a company and that they are comfortable with its business plan and
prospects.

However successful it may have been in freeing up
cash for SMEs, the Government’s £80billion Funding For Lending scheme has meant
that the banks now have a cheap source of funding and no longer need to work as
hard to get funds from savers. Already historically low, interest payments have
come under further pressure and many savers have had to eat into their
reserves; consequently alternative sources of income such as retail bond
dividends have become even more attractive.

Mr Bond says... "Potential investors should consider the duration of the bond – those
issued for less than five years cannot be wrapped into an ISA and therefore
attract income tax at the individual’s highest marginal rate – and only those
listed on ORB will be traded in the secondary market."

Potential investors should consider the duration of the bond – those
issued for less than five years cannot be wrapped into an ISA and therefore
attract income tax at the individual’s highest marginal rate – and only those
listed on ORB will be traded in the secondary market.

However, a listing is no guarantee of liquidity and the value of bonds
in poorly performing companies may decline in line with shares in the business;
those needing to liquidate assets before the maturity of the bond may find that
the value of their capital investment has fallen.

In the extreme circumstance that the issuing
company should fail, despite the fact that historical data suggests that levels
of capital returned to the investor are actually quite high, there is no
recourse to the Financial Services Compensation Scheme, so the lure of an
attractive coupon should always be viewed in light of the attendant risk.

Eden Riche, Head of Debt Capital Markets at
Investec confirmed RBE’s stance: ‘The fact is that there’s no free lunch.
This really is a case of caveat emptor — let the buyer beware.’

However unlikely it is considered in the short
term, a further risk worthy of consideration would be that created by an
interest rate hike by the Bank Of England.
In this instance companies issuing new bonds would
then have to pay higher interest rates to remain attractive; if investors began
to offload older bonds to seek greater returns, prices would be
likely to fall for those selling early.

Clearly, the purchase of a retail bond should only
be considered once all factors have been considered, and the sector has been
clouded by some of the non-financial incentives offered by those issuing
‘loyalty bonds’.

Patrick Connolly, of financial adviser Chase de
Vere, remarks: ‘There are all sorts of companies bringing their bonds to market —
and it’s vital you don’t go into this blindfolded.
‘Let’s be clear, not one of these companies has
gone under or even looks like doing so. But the risk is crystal-clear: anyone
buying a bond is exposing themselves to the fortunes of just one company.’

Ben Yearsley, head of research at broker Charles
Stanley, says: ‘As more people pile into these types of investments, seeking an
alternative to the small amounts of savings income on offer on the High Street,
it’s absolutely critical to know what you’re buying.
‘Although retail bonds can be a good investment,
make sure you understand the company’s business plan, its products and what it
really does.’

In light of the Co-op Bank conversion, it appears
that would-be investors not only have to weigh the risk-reward potential of a
particular retail bond issue, but need to be aware of the range of consequences
of taking a position should things go against the business they propose to lend
to.